What should I do when the stock price drops by 30%?
Knowledge is a very powerful tool. Investing requires knowledge and familiarity of the companies that you choose to plough your hard earned money into. This may be a good reason not to own too many stocks but invest within your circle of competence. You need to have a diversified portfolio but not beyond what you can handle. For instance, I am visiting Breadtalk during breakfast, lunch and dinner to observe the crowd, the service level and menu. I will try to understand the price level and when they will increase price and give promotions to drive sales. You need to understand the companies you want to invest in thoroughly and its external factors such as competition and macro factors.
Know nothing about the company
I was having this chat with my mum this morning and questioned her why she bought InnoPac. I glanced through the Annual Report which was mailed to the house and immediately threw it aside. My mum explained back then there was a bull run and every single stocks had increased two to three folds and only this stock was like a few cents. Then they put their money into it and never see it grow past their initial investment. When I asked her what does the company do? What was the business behind the company? She just shrugged. Cheap does not mean the stock is good. My friend’s girlfriend asked me whether she should buy penny stocks. I said,” Unless you know the companies well, please don’t throw away your money and buy ETF instead.” As she is not into trading but want to invest thinking penny stocks are less pricey and can buy more of it with her monthly saving. I was burnt in the past with penny stocks and one of them was de-listed. It is in my portfolio to serve as a gentle reminder.
When the stock price is going up is not good enough reason to own the stock and keep it in the portfolio. Likewise, when the stock price is going down is not a reason to sell as well. In the short run, the market is a voting machine and in the long run, the market is a weighing machine. Firstly, you need to understand the business of the stock that you own.
Determine whether it is a good company
The company’s success is related to the stock’s price. It is imperative to focus on the long term and look at future earnings instead of historical earnings. You need to understand that profitable companies in today context may be future losers because new competitors will come into the market and erode their margin. Do you still remember Nokia handphone? It used to be very profitable until the smart phones came along. Apple replaced Nokia and dominate the market for a few good years. Apart from the business, you need to question what is the competitive advantage the company has over the competitors and whether the economic moat is deep and wide enough to fend off other competitors. With all these in mind, you just need to be patient and wait for the price to drop until it reaches a level with sufficient margin of safety. Then you just need to buy more of the company’s shares. Margin of safety is important to protect you from unforeseen factors which blindsided your judgement.
Volatility in the market
Volatility is good for the market. After the meeting in Doha failed, the share price dropped and the very next day, the share price recovered. Stock market price movements are nothing to be concerned about. You should be happy when there is volatility in the market, especially when the stock price drops. Mr Market is presenting a discount to the price and it is a great opportunity to snap up this bargain.
Warren Buffett said: “Price fluctuations are there to provide opportunities to buy wisely when prices fall sharply. At other times you would do better to forget the market and pay attention to the operating results of companies.”
You should not focus on the price but focus on the fundamental of the business. You should only sell the stock not when the price drops by 30% but when the company’s business has deteriorated and it is an irreversible situation. You need to remember that you are a long term investor and not a short term trader. Seat back and collect dividend!